CORPORATE  FINANCE  REVIEW  FOR  FIRST  QUIZ  

Aswath  Damodaran  

2

Basic  Skills  Needed  

¨  What  are  the  potenDal  conflicts  of  interest  that  underlie  a  business  and  how  do  they  manifest  themselves  in  pracDce?  

¨  Can  you  read  a  regression  of  stock  returns  against  market  returns?  ¤  How  would  you  use  the  intercept  to  measure  stock  price  performance?  ¤  What  does  the  slope  of  the  regression  measure?  ¤  What  does  the  R  squared  of  the  regression  tell  you  about  risk?  

¨  Can  you  use  the  beta  to  esDmate  an  expected  return  on  an  investment?  

¨  .What  are  the  three  factors  that  determine  betas?  ¤  What  is  the  relaDonship  between  leverage  and  beta?  ¤  How  do  you  esDmate  a  new  beta  if  a  firm  changes  its  leverage?  ¤  In  general,  how  is  the  unlevered  beta  related  to  the  assets  that  a  firm  has  

on  its  balance  sheet?  What  effect  do  acquisiDons  and  divesDtures  have  on  this  unlevered  beta?  

3

Corporate  governance..  Use  common  sense…  

¨  Assume  that  you  are  currently  a  stockholder  in  a  firm  that  is  the  target  of  a  leveraged  buyout.  From  the  perspecDve  of  conflicts  of  interests  between  you  and  management,  which  of  the  following  should  concern  you  the  most  about  this  transacDon?  ¤  The  fact  that  the  company  will  go  private  aUer  the  transacDon  ¤  The  possibility  that  equity  investors  in  the  LBO  can  make  huge  returns  ¤  The  fact  that  the  managers  of  your  firm  are  also  part  of  the  acquisiDon  team  ¤  The  use  of  a  disproporDonate  amount  of  debt  to  fund  the  transacDon  ¤  None  of  the  above  

¨  We  usually  see  the  stock  prices  of  the  target  firm  in  an  LBO  jump  on  the  announcement  of  an  LBO.  This  can  be  viewed  as  evidence  that  ¤  Markets  are  inefficient  ¤  Markets  are  efficient  ¤  Cannot  tell  without  more  informaDon  

4

Reading  a  Regression:  The  Intercept  

Intercept  –  Rf  (1-­‐  Beta)  =  Jensen’s  alpha  

This is what the stock

actually did in a month in which the market did

nothing

This is what the stock was

expected to do in a month in

which the market did

nothing

Excess Return

5

Key  concepts  to  keep  in  mind  about  the  intercept  

¨  It  is  the  difference  between  the  two  (the  intercept  and  the  riskfree  rate  (1-­‐beta))  that  macers  

¨  The  intercept  and  the  riskfree  rate  have  to  be  stated  in  the  same  terms  –  if  one  is  monthly,  the  other  has  to  be  monthly  as  well.  

6

An  Example  

¨  You  have  run  a  regression  of  returns  of  Devonex,  a  machine  tool  manufacturer,  against  the  S&P  500  Index  using  monthly  returns  over  the  last  5  years  and  arrived  at  the  following  regression:  

ReturnDevonex  =  -­‐  0.20%  +    1.50  Return  S&P  500  ¨  If  the  stock  had  a  Jensen’s  alpha  of  +0.10%  (on  a  monthly  basis)  over  this  period,  esDmate  the  monthly  riskfree  rate  during  the  last  5  years.  

7

The  SoluDon  

Data  given:  Jensen’s  alpha  =  0.1%,  Intercept=  -­‐0.2%,  Beta  =  1.5;  Find:  Riskfree  rate  The  Jensen’s  alpha  is  the  difference  between  the  actual  intercept  and  the  expected  intercept  of  Rf(1-­‐b).  

-­‐0.20%  -­‐  Rf(1-­‐1.5)  =  .10%;  Solving,  we  find  that  Rf  =  0.6%.  

What  if  I  had  asked  you  for  an  annualized  riskfree  rate?  

8

Annualizing  Rates  

¨  Annual  Riskfree  Rate  =  (1.006)12  -­‐  1  =  7.44%  

¨  What  if  I  had  told  you  that  the  Jensen’s  alpha  was  2.4%  on  an  annualized  basis  (instead  of  0.1%  on  a  monthly  basis)?  ¤  Since  your  regression  is  in  monthly  terms,  your  Jensen’s  alpha  would  have  to  be  converted  to  monthly  terms.  

¤  The  simple  conversion  is  2.4%/12  =  0.2%  ¤  The  compounded  version:  (1.024)1/12-­‐1  =  .0198%  

9

From  betas  to  expected  returns…  

¨  Beta  is  a  measure  of  the  market  risk  in  an  investment.  The  expected  return  on  an  equity  investment,  which  is  also  the  cost  of  equity,  can  be  wricen  as  

¨  Cost  of  Equity  =  Riskfree  Rate  +  Beta  (Risk  Premium)  ¤  The  riskfree  rate  should  generally  be  long  term,  default  free  and  currency  matched.    ¤  The  risk  premium  is  generally  esDmated  from  historical  data.  It  should  be  defined  

consistently  with  the  riskfree  rate.  For  emerging  markets,  an  addiDonal  country  risk  premium  may  have  to  be  added  on.  This  country  risk  premium  can  be  esDmated    n  Simply  by  adding  the  default  spread  based  upon  the  country  raDng  to  the  US  

risk  premium  n  In  a  more  sophisDcated  way,  by  esDmaDng  the  relaDve  equity  market  volaDlity  

and  then  adjusDng  the  default  spread  for  this  relaDve  volaDlity.  ¤   The  risk  premium  can  also  be  esDmated  from  the  market,  in  which  case  it  is  called  

an  implied  equity  premium.  When  we  use  this  premium,  we  essenDally  assume  that  the  market  is  correctly  priced.  

10

The  riskfree  rate  and  risk  premiums:  An  example  

¨  You  have  been  asked  to  review  a  beta  regression  done  on  Cemex,  a  large  Mexican  cement  company,  and  the  output  is  provided  below:  

ReturnsCemex  =  0.25%  +  1.08  ReturnsBolsa  R2  =  45%  ¨  The  Bolsa  is  the  Mexican  equity  index  and  the  regression  was  done  

using  two  years  of  weekly  returns.  ¨  Assume  now  that  the  beta  from  this  regression  is  correct  and  that  

you  are  trying  to  esDmate  the  cost  of  equity  for  Cemex  in  Mexican  pesos.    

¨  The  ten-­‐year  Mexican  Government  bond  rate  in  pesos  is  8.35%  but  the  Mexican  government  has  a  local  currency  raDng  of  AA,  with  a  default  spread  of  0.65%  associated  with  the  raDng.    

¨  The  risk  premium  for  the  US  and  other  mature  markets  is  about  4%  and  Mexican  equiDes  are  three  Dmes  more  volaDle  than  Mexican  bonds.  EsDmate  the  cost  of  equity  in  pesos.            

11

EsDmaDng  cost  of  equity…  

¨  Riskfree  rate  in  pesos  =  Mexican  Peso  10  year  rate  –  Default  spread  for  AA  rated  bond  =  8.35%  -­‐  0.65%  =  7.70%  

¨  Risk  premium  for  Mexico  ¤  Equity  risk  premium  for  US  (mature  market)      =  4.00%  ¤  AddiDonal  Risk  premium  for  Mexico  =  0.65%  (3)    =  1.95%  ¤  Total  Equity  Risk  Premium  for  Mexico      =  5.95%  

¨  Cost  of  Equity  ¤  Riskfree  rate  =  7.70%  ¤  Beta  =  1.08  ¤  Risk  premium  =  5.95%  ¤  Cost  of  equity  =  7.7%  +  1.08  (5.95%)  =  14.13%          

¨  How  would  your  answer  be  different  if  I  told  you  that  Cemex  gets  half  its  revenues  in  the  US  and  half  in  Mexico?  ¨  Cost  of  equity  =  7.7%  +  1.08  (0.5*4%+  0.5*5.95%)  =  13.07%  

12

Betas  and  Fundamentals  

¨  The  beta  of  a  firm  reflects  three  fundamental  decisions  a  firm  makes  a.  The  type  of  business  it  is  in,  and  the  products  and  

services  it  provides.  The  more  discreDonary  these  products  or  services,  the  higher  the  beta.  

b.  The  cost  structure  of  the  business  as  measured  by  the  operaDng  leverage  

c.  The  financial  leverage  that  the  firm  takes  on;  higher  financial  leverage  leads  to  higher  equity  betas  

13

The  Example:  Financial  Balance  Sheet  

Assets LiabilitiesTobacco $ 15 billion Debt $12.5 billionFood $ 10 billion Equity $ 12.5 billion

Total $25 billion Total $ 25 billion

You have been asked to estimate the levered beta for GenCorp, a corporation with food and tobacco subsidiaries. The tobacco subsidiary is estimated to be worth $ 15 billion and the food subsidiary is estimated to have a value of $ 10 billion. The firm has a debt to equity ratio of 1.00. You are provided with the following information on comparable firms: Business Average Beta Average D/E Ratio Food 0.92 25% Tobacco 1.17 50% All firms are assumed to have a tax rate of 40%.

14

CalculaDng  the  Unlevered  Beta  

¨  To  find  the  unlevered  beta  of  the  firm,  we  need  the  unlevered  betas  for  tobacco  and  food.  The  betas  given  for  the  industry  are  levered  betas  (regression  betas  always  are),  and  the  average  debt/equity  raDos  for  the  industry  are  used.  ¤  Unlevered  Beta  for  Food  Business  =  0.92/(1+(1-­‐.4)(.25))  =  0.8  ¤  Unlevered  Beta  for  Tobacco  Business  =  1.17/(1+(1  -­‐  .4)(.5))  =0.9  

¨  How  would  your  answers  have  changed  if  I  told  you  that  the  average  cash/firm  value  of  companies  in  both  businesses  was  10%?  

15

An  Updated  Balance  Sheet  

Assets Liabilities Value Beta Tobacco $ 15 billion 0.9 Debt $12.5 billion Food $ 10 billion 0.8 Equity $12.5 billion Total Firm $ 25 billion 0.9 (15/25) +

0.8 (10/25) = 0.864

Total Firm $ 25 billion

16

The  Effects  of  Leverage  

¨  Unlevered  Beta  =  0.864  ¨  Levered  Beta  for  the  Firm  =  0.864  (1  +  (1-­‐.4)  (12.5/12.5))  =  1.376  

¨  Cost  of  Equity  =  6%  +  1.376  (5.5%)  =  13.57%    

17

DivesDture  of  food  business  

¨  Now,  let’s  assume  that  the  company  divests  itself  of  the  food  business  and  gets  fair  value  for  the  divesDture?  What  will  happen  to  the  beta  of  equity?  

  Assets LiabilitiesTobacco $ 15 billion 0.9 Debt $12.5 billionCash $ 10 billion 0 Equity $12.5 billionTotal Firm $ 25 billion 0.9 (15/25) + 0

(10/25) = 0.54Total Firm $ 25 billion

Levered Beta for the Firm = 0.54 (1 + (1-.4) (12.5/12.5)) = 0.864

18

Now,  let’s  use  cash  to  pay  off  debt  

¨  Assume  that  the  company  decides  to  use  the  $10  billion  in  cash  to  pay  off  debt.  What  will  happen  to  the  equity  beta?  

Assets LiabilitiesTobacco $ 15 billion 0.9 Debt $2.5 billionCash 0 0 Equity $12.5 billionTotal Firm $ 15 billion 0.9 Total Firm $ 15 billionLevered beta for the firm = 0.9 (1 + (1-.4) (2.5/12.5)) = 1.008

19

What  if  the  cash  were  used  to  buy  back  stock?  

¨  Assume  that  the  company  decides  to  use  the  $10  billion  in  cash  to  buy  back  stock.  What  will  happen  to  the  equity  beta?  

Assets LiabilitiesTobacco $ 15 billion 0.9 Debt $ 12.5 billionCash 0 0 Equity $ 2.5 billionTotal Firm $ 15 billion 0.9 Total Firm $ 15 billionLevered beta for the firm = 0.9 (1 + (1-.4)(12.5/2.5)) = 3.60

20

What  if  the  cash  were  used  to  pay  a  dividend  of  $  2.5  billion,  pay  down  debt  of  $  7.5  billion  

¨  Assume  that  the  company  decides  to  use  the  $5  billion  to  pay  a  dividend  and  the  remaining  $7.5  billion  to  pay  down  debt.  What  will  happen  to  the  equity  beta?  

Assets LiabilitiesTobacco $ 15 billion 0.9 Debt $ 5 billionCash 0 0 Equity $ 10 billionTotal Firm $ 15 billion 0.9 Total Firm $ 15 billion

Levered beta for the firm = 0.9 (1 + (1-.4)(5/10)) = 1.17

21

What  if  the  cash  were  used  to  buy  a  social  media  firm  for  $  10  billion  

¨  Assume  that  the  company  decides  to  use  the  $10  billion  in  cash  to  buy  a  social  media  company.  What  will  happen  to  the  equity  beta?  (Social  media  companies  have  an  unlevered  beta  of  1.80)  

Assets Liabilities Tobacco $ 15 billion 0.9 Debt $12.5 billion Social Media $ 10 billion 1.8 Equity $12.5 billion Total Firm $ 25 billion 0.9 (15/25) +

1.8 (10/25) = 1.264

Total Firm $ 25 billion

Levered beta for the firm = 1.264 (1 + (1-.4)(12.5/12.5)) = 2.02

22

What  if  the  cash  is  used  plus  debt  of  $  5  billion  to  buy  a  social  firm  for  $  15  billion  

¨  Assume  that  the  company  decides  to  borrow  $5  billion,  and  use  it  with  the  $10  billion  in  cash  to  buy  a  social  media  company  for  $15  billion.  What  will  happen  to  the  equity  beta?    

Assets Liabilities Tobacco $ 15 billion 0.9 Debt $17.5 billion Social Media $ 15 billion 1.8 Equity $12.5 billion Total Firm $ 30 billion 0.9 (15/30) +

1.8 (15/30) = 1.35

Total Firm $ 30 billion

Levered beta for the firm = 1.35 (1 + (1-.4)(17.5/12.5)) = 2.48

23

Test  yourself…  

Assets Unlevered

Beta

D/E Ratio Levered

Beta

Sell Asset Replace asset with cash Decrease No effect Decrease

Buy asset with cash on hand

Buy asset with new stock or

equity issue

Buy asset with new debt

Pay dividend

Buy back stock

Retire debt